Monthly Archives: February 2012

“Every attempt to pump up asset prices with cheap money has failed, from John Law’s Mississippi fiasco in 1720 to Bernanke’s recent housing bust. But our economists think this time is different. And for now the market seems happy to go along.” Dylan Grice

After Which Magazine Cover Would you Rather Buy?

February 2012

August 1979

The market is unrelenting – we have not had a single 1% down day on the S&P since the middle of December. Albert Edwards said…

“The market is once again in a hope phase, hoping that the US is now in a self-sustaining recovery; hoping that China might be soft-landing; hoping that the Greece bailout and the ECB liquidity polices have settled things down in the eurozone. These bursts of hope are essential in long bear markets. Essential in the sense that hope must be crushed.”

Volatility is so 2011 and the VIX reflects this hovering around 20. The FTSE All Share was up 3.7% for the month and the Hedge Fund index was up 1.4%. Kelpie was up 3.3% held back by the short positions and the sizable cash weighting.

One question I have been grappling with this month is whether the LTRO(s) of around 1 trillion Euros have changed the game? Clearly the bulls have been right in 2012 so far and Crispin Odey’s comments about the authorities having no choice but let banks earn their spread are proving prescient. Governments and the ECB are providing unlimited financing and liquidity to the banks via the LTRO at 1%. The banks are filling their boots with this cheap money, turning around and buying sovereigns, which carry a zero risk weighting in capital terms, which is the primary cause of driving the yields down and increasing the perception that the crisis is receding and the problem has been solved. Peter is paying Paul to buy things from Peter. This is vendor/Ponzi finance and doesn’t cure much – but it certainly makes everyone feel better in the short term and allows the banks to earn a lovely carry.

The crisis was caused by the mispricing of capital, the Fed and the other major central banks kept interest rates too low for too long. It made debt too cheap and leverage too attractive and too accessible to too many people. It seems that we have learned nothing from the crisis because we are pricing capital near zero again with the LTRO and the Fed’s promise to keep rates anchored at zero until 2014. We are doubling down on a strategy which has proven thus far to be unsuccessful but also to cause a great deal of wealth destruction (eventually).

Two quotes have been playing on my mind….

“If the market has a problem, buy the problem and sell the market because the market isn’t going up until the problem is fixed.” Crispin Odey

“The sector that leads you into trouble does not lead you out.” David Yarrow

Both of these are quite interesting and could provide impetus to the bulls or bears at this stage. Looking at history and the Japanese bubble, their real estate and equity prices; the Tech bubble and the Nasdaq’s subsequent performance makes me think that I side with Yarrow.

I think the portfolio had a good February, there were some very strong individual performers like Yukon Nevada (38%), Dart Group (17%) and Gravity (48%) which were very gratifying and all 3 were reduced into strength. However for the second month in a row it has been my conservative positioning that has held the portfolio back. Performance is going to be driven primarily by the core equities in the long book tempered or aided by the net exposure from macro or market shorts which are intended to protect the portfolio from the 100 Year Storm, or 7 Standard Deviation event, that we now seem to have with increasing frequency in financial markets.

When it comes to engaging with the market I try to let history be my guide. This would suggest that there shall almost certainly be better times to invest than now. When these opportunities arise they will likely be preceded by an abrupt and unheralded drawdown in speculative gains and risk appetite.

John Hussman was quite explicit in his 20th February note about the stability of the market and it’s susceptibility to a sharp correction. These conditions or syndromes as he calls them are completely distinct from the economic worries we may or may not soon face.

“As one of many ways to define “overvalued, overbought, overbullish, rising yield” conditions, consider the points in history when the S&P 500 was at a “Shiller” multiple of over 19 times 10-year inflation-adjusted earnings, the index was at least 8% over its 89-week moving average, within 2% of a 3-year high, with Investors Intelligence sentiment over 45% bulls, less than 30% bears, or both, and with at least one yield measure above its level of 26-weeks earlier (corporate, Treasury bond, or T-bill). This set of conditions produces a cluster restricted to about 8% of market history, and also self-selects for many of the worst times an investor could have chosen to buy stocks, based on the depth of the market’s decline within the following 18 months.

While the criteria above are loose enough to include several false signals, the periods also include late-1961 (-25%), early-1966 (-20%), late-1968 (-30%), late-1972 (-30%, and a nearly -50% loss extending beyond that 18 month window), mid-1987 (-33%), mid-1998 (-12% over the next 13 weeks), mid-2000 (-35%, and a loss of more than 50% beyond that 18 month window), and mid-2007 (-55%).”

This is sufficient warning to me that we need to remember that optimism can hurt. Robert Rodriguez highlighted what he calls “the investor delay recognition period” where market participants, particularly equity market participants do not yet fully grasp, due to their lack of awareness of historical context, the severity of the danger they are in or the magnitude of the risks they are taking.

Patents & Intellectual Property

“Knowledge is Power.” Sir Francis Bacon (1597)

Intellectual Property and Patents is a theme that permeates amongst several holdings within the portfolio. Alan Greenspan once called technology “the embodiment of ideas” and it is clear that in the modern age capitalism is driven by brains rather than the brawn that drove the industrial age. The course of history has shown us that innovators and inventors who can take “the inventive step” can become the recipients of supernormal profits. For context, in July 2011, a consortium of technology firms acquired Nortel’s portfolio for $4.5bn, and following the Nortel transaction, Google agreed to acquire Motorola Mobility for $12.5bn with many commentators speculating the bulk of Google’s interest was founded upon Motorola’s patents. There is a global arms race for intellectual property afoot. Aware Inc , Microsoft, Genie Energy and IDT Corp are all stocks where I think substantial upside resides in the value of their IP assets.
The marvellous thing about IP assets is that once you own them you can receive cash flows for no incremental investment and you have a tangible, defendable moat. These cash flows are incredibly high margin and sometimes the assets are so strategic that they are purchased at great expense by larger incumbents.

I view these assets as “free shots on goal” – some will miss but some might score big. Aware Inc’s portfolio of patents has around a 50% classification crossover with Nortel and Motorola’s portfolios focus on digital communication, encryption and digital transmission. To use a sales comparison metric we can see that Motorola received around $450,000 and Nortel received around $750,000 per patent. Aware has 456 patents so assuming that they could receive only $100,000 on average then these assets are worth well in excess of 50% of the current market cap of the company.

IDT owns “Fabrix” which is a video software storage platform which they say has received interest from the Mega Caps as a bolt-on acquisition. IDT also owns “Zedge” which is the most popular mobile content community site in the world visited by more than 40 million unique users every month. Given the Social Networking stocks are all currently trading at egregious multiples this asset is worth something. IDT Corporation also owns VoIP (Voice over Internet Protocol) patents and has spent millions trying to defend them. This demonstrates the value that management see in the assets and further shows another way that IP owners can defend and monetize their rights.

Genie Energy (a spinoff of IDT) owns a technology which they believe can extract shale oil by heating up the rock in the ground and extracting the oil from the ground in liquid form without serious surface disruption. They believe this method is cheaper and more environmentally friendly. CEO Howard Jonas puts breakeven at $25 per barrel, with oil at over $100 there is a decent margin to be earned. This technology and the economics it would generate on their oil assets make this a very dull business with a strong balance sheet, a 2% yield and a call option on a 20x return.

Aberdeen seeks to acquire equity participation in pre-IPO and early stage public resource companies with undeveloped or undervalued high-quality resources. Aberdeen focuses on companies that: (i) are in need of managerial, technical and financial resources to realize their full potential; (ii) are undervalued in foreign capital markets; and, (iii) operate in jurisdictions with low to moderate local political risk.

Aberdeen is essentially a vehicle through which director Stan Bharti and CEO George Fauth invest in publicly traded and occasionally private resource companies. Both individuals are also involved in running the privately-owned Forbes & Manhattan (“F&M”) investment banking group which was founded by Mr Bharti. They leverage the existing infrastructure and expertise within F&M as needed in helping with the investment portfolio. That infrastructure includes the expertise of 25 geologists, 25 engineers, 6 lawyers, 30 bankers and capital market professionals and finally 15 administration and accounts staff.

Because of its focus on the “seed stage” Aberdeen provides something akin to “Venture Capital for mining companies.” Like a VC, it typically takes board seats and gets involved with management, corporate finance, marketing and infrastructure. It usually holds investments for 2-3 years. Since inception 4.5 years ago they have an IRR of 67% on their investments – does that sound like it deserves a discount to NAV?

Aberdeen now trades at just less than half of its investment portfolio NAV of $1.15 as of 10/31/2011

This NAV is liquid, tangible and easy to calculate: it is cash and listed equities although admittedly the equities are small caps and fairly thinly traded.

This NAV is supplemented by additional valuable assets such as their 2 gold royalties in South Africa and some “performance shares” as explained below.

Stan Bharti, the CEO describes Aberdeen International as follows…..

“Many people on The Street, so to speak, and many funds in the financial sector find a lot of the juniors that Forbes invests in—or that I invest in personally—too small. Raising $5 million to $10 million isn’t enough for big funds to come in. So we created Aberdeen International Inc. (TSX.V:AAB), and raised $100 million or so in Aberdeen. The model for Aberdeen is that any time I invest in a junior company at the seed level, Aberdeen co-invests with me. This gives investors indirect exposure to all of Forbes companies.”

Portfolio

The portfolio of equities that Aberdeen owns is reasonably well diversified. Just less than half is Gold Mining equities. Near 2/3rds are public equities.

The Top 5 holdings:

1. Sulliden Gold (TSE: SUE). This is a gold & silver exploration company developing a mine in Peru which is expected to start production in 2013H2. The stock is covered by seven analysts, all of whom recommend it as a buy, with an average PT of $3.42 vs. a current price of $1.50 per share.

2. Temujin Mining Corp is a private company for the moment and carried at cost. World class licenses covering two of the most exciting advanced projects on Oyu Tolgoi copper-gold belt in Mongolia

3.Crocodile Gold (TSE: CRK) acquires, explores and develops gold fields in the northern territories of Australia. This stock has been subject of a Value Investors Club write up and this is linked to in the appendix. That write up suggests it is worth $1.15 relative to a current share price $0.56.

4. Forbes & Manhattan Coal Corp. (TSE: FMC) FMC is a coal miner, with mines in South Africa. The stock is covered by five analysts, all of whom recommend it as a buy, with an average PT of $4.08 vs. current price $1.85 per share.

5. Black Iron Inc. (TSE: BKI), which is developing an iron-ore mine in Ukraine, expected to start production in 2016. The stock is covered by seven analysts: 6 buys and 1 hold, with an average PT of CAD 1.56 vs. a current price of CAD 0.70.

The Top 5 holdings are 32% of the portfolio and there are 20 other holdings of smaller sizes. The Portfolio contains other names that I have seen other value investors involved with too in Dacha Strategic Metals (itself at a huge discount to NAV of rare earth metals) and Alderon Resources.

Stan Bharti describing Avion Gold Corp (TSE: AVR) to illustrate his point around what an investment of theirs should be like:

“We acquired the assets about three years ago for $20 million. It had a fully permitted plant, all the infrastructure at the site and three to four million ounces in gold resources. Then we hired President and CEO John Begeman, who was with Goldcorp Inc and with him and with a top-notch management team, we worked the asset. Today, the mine is producing almost 100,000 ounces per year, it has a market cap of close to $400 million and we think that in the next two or three years that this stock has the potential to double.”

Dealing with the Discount

Since inception Aberdeen’s portfolio included some of the biggest home runs in resource investing over the past few years: Black Iron, Sulliden and Avion Gold. F&M under Mr Bharti’s guidance seeded Desert Sun Mining and Consolidated Thomson leading to spectacular returns.

Aberdeen International management is well aware of the discount and are being proactive about it. Combined they own 15% of the shares outstanding. Aberdeen’s President and COO, David Stein, exercised 1.6m options in 2011Q2, more than doubling his stake to 2.8m shares, 3.2% of outstanding. In 2008-10, Aberdeen bought back 7-8m shares per year, contributing to shrinkage in shares outstanding from 103m in Jan 2008 to 87m in Jan 2011 (there were some options issued, too). This has declined further to 86.2m as of 1st February.

Quoting from Alon Bochman @ SC Fundamental Value Fund….

“In 2011, they bought back just 2.5m shares. Aberdeen’s COO told me that they are buying back as many shares as TSX rules allow. TSX restricts buybacks to a certain number of shares per day, a certain percentage of the daily volume, etc. The purpose of the rules is to prevent a company from manipulating the price of its stock. The only exception is if Aberdeen is able to find a block to buy. In 2008-10, they were able to buy plenty of blocks from the same counterparties that bought CAD60m in Aberdeen stock in 2007 (see below). However, in 2011 that supply dried up and Aberdeen has been restricted to the open market. “If you find a block, please let us know,” the COO told me. “We would love to buy it.” Unable to buy back as much stock as it wished, Aberdeen recently declared its first ever dividend in March. The current yield is 3.4%.”

Given the level of the insider ownership and the vast wealth of Mr Bharti, there really is no reason for this company to trade on the public markets if it’s going to trade at such a substantial discount to intrinsic value or even NAV.

Why is it Cheap?

No sell-side research and this won’t ever change. Sell side coverage is very self serving, they only cover something when they might get something in return. Aberdeen will never provide IB business because they will always have F&M on hand to do all their corporate finance or capital markets work.

Aberdeen International is tiny, at only $50m it is way below the radar of almost every institution that runs more than say $100m maximum.

Aberdeen’s share price may have suffered because of a longwinded legal battle: As Alon Bochman describes it….“In 2006, Aberdeen loaned USD10m in seed capital to a South African mining company called Simmer and Jack Mines. The loan came with a 1% net smelter royalty (“NSR”) for the life of the mine. Through a complicated and bizarre set of events the loan became disputed with Simmers claiming no principal was due back. Aberdeen sued for about $13m. The suit was settled in October 2011, for $9m in cash plus the 1% NSR in perpetuity. The $9m in cash is spread into five payments ending February 2012.”

Royalty

The value of the royalty is tricky. Aberdeen have attempted to value it by capitalizing it with the following assumptions:

(1) Life of mines and gold production estimates as per Simmer and First Uranium

(2) $850 gold price through fiscal 2010, and $700 long term

(3) 5% discount rate.

This comes to a total net value of $33.3 million

Now looking at today’s gold price of around $1700 we can see that the value of this royalty is potentially much higher because it will make more of the mines economic and therefore extend the life of the mine and it will obviously increase cash flow.

It has been suggested that royalty companies like Royal Gold or Franco Nevada trade at 10-20x cash flow. The company presentation from Feb 2012 states that they expect to receive $2.2m net over the next 12 months. The resources behind the royalty are very large and therefore the royalty is expected to last for many years to come. It doesn’t seem unreasonable to value that at $22m or $0.25 per share.

Management has a stated desire to sell the royalty and I would imagine this will be around the lowest figure they have in mind. When/if they receive that cash it can be used for further investments or to buyback further stock at this discount.

Performance Shares

Aberdeen has the stated goal of eventually taking its private investments public as a way of monetizing their investment. Clearly the team has historically done this very well with Avion Gold and with F&M via Desert Sun Mining. Performance Shares are shares in now listed companies that accrue to Aberdeen based upon the achievement of certain pre-determined operational or investment milestones.

In his presentation given in June 2011 at the Richmond Club, David Stein suggested that they would achieve milestones both in the near term and hopefully over the next few years where they would receive extra shares for free, which would of course increase the NAV further.

Currently all performance shares that are not vested or earned are carried on the book at zero value so any upside regarding these would be free. Tim Eriksen of Eriksen Capital Management has suggested that the performance shares for just Aquia and Forbes & Manhattan Coal could be worth around $0.10 per share or just over $10m.

He quotes that in a conference call in early 2011 they mention performance shares (non-listed) which they own. They say these could deliver “huge upside over next 2 years”.

Junior Miners – Risky Ventures?

Absolutely! For many reasons but here is Mr Bharti on how these risks can be turned into great returns for investors…

“It’s different in the sense that we actively manage our assets (at Forbes & Manhattan/Aberdeen). There’s a lot of leverage in junior companies. If you can get in early on, with what we call the seed stock—$0.10, $0.20, $0.30 cents—you see these seed stocks grow. Five key elements drive junior companies. One is a good asset. Second is management. Third is the ability to raise capital. Fourth is telling the story, promoting the stock. Fifth is good capital structure.

The difficulty with a lot of the junior companies is that they just don’t have the management depth, the ability to raise capital to take these stocks to a level where they belong. We believe that by taking a junior company with a good asset—a good asset is key—and surrounding it with a lot of depth in terms of management, access to brainpower and capital, and working the asset over four to five years, the rewards can be phenomenal for our shareholders.

We bring all the companies that we invest in into our shop. We surround them with our own lawyers, accountants, IR people, investment bankers, analysts. We have all of them in-house so that a junior company can operate like a major without the overhead of a major.”

Because of the nature of the junior mining industry is of course quite possible that some of the Aberdeen Investments will go to zero, although you would hope their expertise will minimize the chances of this. On the other side, there is the chance for extremely good, but lumpy, returns.

Raising Money?

Management has indicated that they would see their ideal size as $250-500m and therefore they would like to increase their AUM. They have been quite specific that they have no desire to do this when the stock is trading at a discount as it would damage existing shareholders.

It’s difficult to do a post on Tesco because what can I say that hasn’t already been said? Seems unlikely I can add any insight to the cumulative wisdom of the 41 sell side and umpteen buy-side analysts who cover the stock full time? On that basis this is much more qualitative than quantitative.

I think Tesco is a “time horizon arbitrage” long at this stage. The old adage is that profit warnings come in threes and so far we’ve only had one so there may be more bad news to come. Because of this, most of the sell side has taken a big step back and will avoid the stock for a few quarters until we have “more clarity” (and the price has moved one way or the other by 20%). For the buyside, there is a decent amount of risk in being seen to have “topped up” if it falls again because the knives are out for the company right now. For investors who can look out a year or two then I think this is an interesting opportunity which on that kind of horizon, with the help of the dividend, will handily beat the return on the FTSE 100 or on cash.

Description

Tesco PLC is an international retailer. The principal activity of the Company is retailing and associated activities in the United Kingdom, China, the Czech Republic, Hungary, the Republic of Ireland, India, Japan, Malaysia, Poland, Slovakia, South Korea, Thailand, Turkey and the United States. It is the market leader in the UK, Thailand and South Korea. The Company also provides retail banking and insurance services through its subsidiary Tesco Bank. Its online businesses include online grocery and Tesco Direct.

Market Cap (£) £26bn

Price 325p

P/E 10x

Dividend Yield 4.5%

Dividend Cover 2.2

Piotroski Score 8

Investment Case Summary

Quality

Tesco is twice the size of its UK peers. Size and scale matter in this business, look at Wal-Mart’s operational performance. Tesco has a long history of operational excellence, is a market leader and has a strong, investment grade quality balance sheet with expansionary spending mostly behind them. Tesco is one of few businesses that benefits from a negative working capital cycle, they do not have to pay suppliers for goods until after they have already sold them and received payment from customers.

Value

The shares have been significantly de-rated thanks to the company’s first ever profit warning in January. The sell side has become increasingly focused on the metric of LFL sales in the UK business which has been struggling and will be difficult to turn around quickly as operating momentum in grocery retailing is not easily won.

Management have announced they will be rebasing UK profitability by investing in the “customer offer” – in price and in better staffing. They confess they have probably “over-earned” in the UK in the last few years by running the business too lean. An example of this is that the number of employees per 1,000 sq feet of store has declined from 74 to 61 since 2004.

The value opportunity arises because this myopic focus overlooks that there are other parts of the business at FCF inflection points or showing good value. Operationally the business is struggling but we have to remember its history of delivery – for the 2000’s Tesco grew earnings at a compound 11.5% per annum. This isn’t going to happen going forward but this is at least a GDP + inflation growth business.

Additionally, it is interesting to note that three directors and Berkshire Hathaway have purchased shares since the price decline in mid January. Warren Buffett now owns 5% of the company.

Growth

Tesco has a long list of potentially value creating options at its fingertips. It has promised that Fresh & Easy will either start performing or close in the next year or so. At the moment this division loses around £100m a year. The closure of the Japanese business shows a more ruthless approach from management regarding non-core operations – they should either deliver or be closed from now on. The businesses in Korea and Thailand have now achieved critical mass, contributing 10% and 5% of profits respectively. Asian operations are expected to produce almost £700m of profits in 2012.

Tesco Direct provides the online shopping element of TSCO, groceries and non-food. Interestingly online sales are done at an 8% margin rather than a 6% margin for the business as a whole so this businesses growth should help going forward. However, the true look through margin differential may actually be less impressive given that many of the costs of the online business are borne by the normal stores where “pickers” collect the shopping before it is sent out to customers. This will likely be addressed overtime by moving online business to centralised “dark stores” and distribution centres where there are no customers only staff focused on fulfilling online orders. The benefit of this is that the stores can be built on much less expensive real estate and do not have to be quite as aesthetic.

Although non-food Tesco Direct – which sells home, clothing and electronics etc is currently a weak part of the business because the UK economy is weak and because it takes up a lot of expensive floor space in the hypermarkets I do not believe this shall always be so. Looking 5 years out I think the UK High Street is doomed, sales are going to move online to Amazon/Tesco.com/SportsDirect.com/ASOS and the incumbents like Comet/Argos/Dixons/Matalan are going to start dropping like flies. They cannot offer the same range of products and they can’t sell it at the same margin due to their expensive square footage. Over time we might see the Tesco Direct floorspace in stores become like a shop window for the most popular deals from the 100,000+ products available online.

The services division offers a few “free options” for growth in things like Tesco Telecom which they aim to contribute £150m of profits by 2013 or Dunnhumby which owns consumer information making £80m per annum and finally the insurance business where Tesco are actually the 6th largest motor insurance business in the UK. All of these businesses are materially valuable and robust but they are a little lost within the context of the giant conglomerate.

Business & Management

Strengths

Through “Clubcard” Tesco knows its customer’s shopping habits better than any of its peers. Historically, Tesco’s retail execution has been very strong with its multi-format flexibility allowing it to closely align store space with its target markets and target customers.

Weaknesses

Management have no credibility yet due to short track record and a failure to deliver on initiatives. It seems the new CEO may have been thrown a “hospital pass” upon taking the job. There are worries that its decades of success have left Tesco a sprawling conglomerate suffering from “mission creep” and perhaps a little complacency.

The highest P/E multiples are placed on focused specialists rather than generalists. For example, management must ask why they are in the garden centre business when it doesn’t move the needle and just provides a distraction.

The dramatic lowering of profit expectations has allowed the doubters of Tesco to jump on the bandwagon citing that the business has been run too hard for efficiency, it has become complacent, there are cultural issues and that their marketing effort has been weak.

Margins are going to be a bit weaker in the UK business due to the “over-earning” issues from the past. Tesco do however have the best margins in the sector so a move back towards its peers is now getting priced into the market.

Opportunities in Tesco Bank

Hypermarkets may be ex-growth but Tesco has many opportunities in the smaller stores like Extra or in the roll out of the Services division, particularly Tesco Bank which is just rolling out its mortgage offering in the UK. I think Tesco has a very large opportunity here to steal basic banking/savings/deposit business from the incumbent major UK banks. RBS, Lloyds and to a lesser extent Barclays have permanently impaired their reputation and their relationships with their customers. Tesco may have a reputation as a big, nasty profit sucking corporation but not to anything like the same degree as the banks. For banking, TSCO’s ubiquity and brand recognition will help. The placing of “branches” in the stores will save money because there is no incremental high street real estate required and furthermore they are guaranteed footfall from the stores.

At the moment Tesco Bank is a negligible part of the business (circa £150m of profit) but in 10 years time it’s possible that they will have considerable market share. Analysts have been quite explicit that there is no risk at this stage that the bank will jeopardise the broader Tesco balance sheet with undue financial risks.

Opportunities in Real Estate

The Tesco freehold real estate portfolio was valued as of the last annual report at roughly £32 billion. I think the sell side is almost completely ignoring this asset backing because of their focus on the income statement and the fact its inherent value is a slow burning process. The property assets provide a degree of inflation protection too.

The stated aim of selling down the real estate portfolio over time to realise imbedded profits, whilst implementing the new commitment to limiting the capex on expanded on store expansions in the UK will materially shift FCF in a positive direction. UK Capex was £2.6bn in 2008 and some analysts estimate this new rationalization could take this down to £1.3bn by 2014 which could add 5% to the FCF yield.

Tesco has been selling down real estate assets at a rate of around £1bn a year realising £200-300m of profit – this could be ramped up going forward and there are further considerations of a Thai Tesco REIT or other such OpCo/PropCo options.Threats

Consumer sentiment towards “big business” is poor, exemplified by campaigns from high profile TV chefs amongst other things. This trend has yet to translate towards sales moving away from the Big 4 however – this seems unlikely due to their one stop, price competitive position. Depending on one’s macro view, Tesco’s non-food exposure is a threat relative to its peers. Austerity induced fiscal drags and fuel price inflation which takes significant wallet share will be a secular headwind for consumer spending going forward.

There is an unfavourable supply/demand dynamic in UK Food retail currently. Sales growth is slow and slowing but industry floor space is still expanding, this points towards some leaner years ahead for profits.

What Needs Work?

Marketing has been poor for years and there is a less clear brand message than MRW and SBRY in particular. There is also less impetus in the own brand products than the peers and it seems to be coasting on the fact it is all things to all people. There is no attempt via product or store architecture to differentiate or target particular customers. A store in a high end area will appear almost identical to a store in a poorer post code. Stores remain industrial and bland feeling with “character” being sacrificed for lean productivity.

Tesco has a very attractive final salary pension scheme relative to peers and it is a major draw or retainer for lots of Tesco staff. It seems like the profit warning will be a good opportunity for management to take steps to “rationalise” or “right-size” this pension promise that they really no longer can afford.

Competitive Position

Supplier Power

The UK food retail market is highly consolidated, has high levels of property ownership, national pricing and relatively flexible labour laws. Tesco’s scale and buying power means it exerts considerable pressure over its suppliers.
The four big players in the UK – TSCO, MRW, SBRY and ASDA are pretty rational. In 2000 they had a combined 55% share of a £50bn market, now they have a 70% share of an almost £100bn UK food market. Tesco’s share is largest at around 30% of the market. All are listed and all have the same time horizons. It seems unlikely that a price war is anyone’s best way to take share from anyone else.

Food retail in the UK is a very competitive business and continuing operating weakness in the UK does not bode well for Tesco’s market share. As of today however they are still very dominant.

UK Food Retail has significant barriers to entry due to the enormous economies of scale in the incumbent market leaders. There is also a degree of loyalty amongst consumers who tend to change where they shop slowly due to habitual behaviour.

Customer Power

Tesco’s market dominance has allowed it to permeate many aspects of its customer’s lives but they do retain the ability to “vote with their feet”. It would seem that customer’s habits are somewhat sticky and often shop in the supermarket closest to them.

Management Incentivisation

Compensation was changed to focus on ROCE since 2006 and the target is from today’s 12.9% to 14.6% by 2014.

This focus on ROCE will only hasten the team to deliver on or close Fresh & Easy like they did in Japan. There should be some natural improvement in ROCE as the project pipeline of stores roll off and open and are not replaced with the same intensity of development.

Management will receive bonuses of between 225-300% of salary if they can achieve compound EPS growth of 12% over the three years to 2015.

Conclusion

The investment case for Tesco remains the same as it was a year ago, the major capex of rapid UK store and overseas expansion is largely behind us – critical mass has been achieved. This leaves Tesco now trades two standard deviations below its long term P/E multiple.

We expect management to start to focus on shareholder returns and customer satisfaction. There are a number of relatively easy to implement options that can be deployed to start to bring the intrinsic value of the business to the market’s attention. Warren Buffett and the Directors of this business know it well and they have been adding to their already sizable holdings. The share price decline from 400p to 320p presents a fantastic opportunity for long term investors to pick up a consistent, market leading, asset backed franchise at a discount to the value of its bricks and mortar.

A friend of mine and their partner work at Tesco and so I sought their opinion on a number of the criticisms recently raised by analysts and their thoughts on the steps management would be taking to address the issues. I attach below their comments verbatim.

What I find interesting is that these problems were very visible on the ground but yet left unaddressed. However, one might say that at least now the top and bottom of the organisation both know where they were going wrong and are headed in the same direction.“Alas I have seen changes in the past 2 years. I’d say particularly in the past year. Staff who leave are not replaced or replaced with someone with fewer hours or a lower wage. Particular departments run on skeleton staff or no staff at all. They rob Peter to pay Paul. All this is amounting to a growing unrest amongst staff, low morale, less energy. Personally, I don’t enjoy my job 70% of the time, mainly because I don’t have the time or resources to fulfill customer’s needs. New staff are not being offered the same Sunday rate as current staff (150%). New service desk staff are not awarded a premium, they are offered the same rate as a checkout/shelf stacker.
The Big Price Drop was introduced by closing all stores overnight in order to change prices/promo material. Customers expected massive bargains and instead received goods at the same prices they were a few weeks earlier – it’s nuts! I’m not sure how well my store relates to the mean but my outlook is pretty bleak. (Name) would love to move elsewhere but I still think he’s in one of the safest jobs he could have currently.”“Customers believe there are many things done to deliberately trick them into buying goods at a higher price than they believe. Shelf edged promos and promo labels are often a bit misleading. Promos “From £1” merchandising posters are next to products where only about 25% of the goods are £1.

I could go on listing the negatives but I think it’s important to mention the positives. Unfortunately, many customers are unaware of Clubcard points and their rewards. Some customers, including myself, revel in the scheme whereby Tesco reward loyalty by issuing money saving vouchers which may be used against grocery shopping or traded for 4x their value to spend elsewhere. Many customers do appreciate this but it doesn’t deal with the immediate shopping experience. I reckon change is needed whereby honesty is key. Customers want to be able to do their shopping quickly and efficiently, they want to glance at the price and know it’s what they’ll pay at the checkout.”

“In stores you have general assistants, team leaders, department managers, senior managers, deputy managers and store managers. I think team leaders are surplus to requirements, except at checkouts. Dept managers vary widely in competence. It seems to be a case of who your chums are and not what you know that sees you through to management – at least this is the only way I can explain what I have seen. Deputy Managers are like floor managers and Senior Managers, of which there are 3 or 4 in my store, are not so hands on, but its variable.
Beyond that there are directors who look after groups of stores across the country. There are also floating managers who take on roles out with their job description/special projects to be rolled out to different stores.”

“When it comes to produce items, I wouldn’t buy fresh fruit or veg from ASDA (Wal-Mart subsidiary) because I don’t believe it’s as fresh. I get all mine straight from the fruit market. Tesco is a mixed bag. I prefer Tesco overall. If Marks & Spencers was larger and less expensive it would win hands down. As for the competition, I am not a huge fan of ASDA as I just couldn’t do a full shop there, it’s too basic/low end. Sainsburys seems of a very similar quality to Tesco but is overpriced. I’ve never liked Morrisons as I believe it lacks variety.”

“The art of getting rich consists not in industry, much less in saving, but in a better order, in timeliness, in being at the right spot.”

Ralph Waldo Emerson

And so we wait for the right spot and the right time….I see more evidence each day that people are being bullied by our policy makers into taking undue risks with their hard earned money. Zero interest rates until at least 2014. What message does that send to the beleaguered, retiree who lives off the interest income on her savings accounts?

ZIRP is forcing people to take risks that they normally wouldn’t dream of. It has been said that “John Bull can stand many things, but he can’t stand zero percent.”. I read somewhere that a record number of new shares have been created for the US High Yield ETF, hot money is pouring into this sector in a reach for yield. The perception is that this credit spread is now relatively safe because companies have so much cash on the balance sheet and default rates are very low. Emerging Market Bonds are back on the radar for their “better balance sheets” and higher yields. This trade may have a little more juice left in it but when the retail investor is getting involved in things they almost certainly don’t understand, I think alarm bells should be ringing.

For January, the FTSE All Share increased 2.6% and the Hedge Fund Index rose 1.5%, Kelpie Capital increased 1.9% in what felt like a tortuous month. Being too defensive throughout January was wrong, but I would argue that’s only the case in hindsight. Outcome-bias and backwards rationalization means decisions are assessed not by the soundness of the process that generates them, but by the actual result. I believe my approach is prudent and reticent of the facts. Markets are currently “awash with liquidity” thanks to the LTRO operations and the aforementioned promise of low rates to infinity and beyond. I believe that the most attractive opportunities are presented when markets are devoid of liquidity. When you can be rewarded by the market for being the provider of liquidity as the purchaser of assets from distressed sellers – that is when you want to be “balls to the wall” bullish; not when after three years we still can’t claim this to be anything other than the worst “recovery” since the Depression.

I commented last month that I was selling Cisco and Western Digital because I expected them have a weak Q1 because much of their sales would be brought forward into Q4. I also said I liked them and would like to own them again. Naively, I overlooked that they would report Q4 in Q1! The stocks are up very strongly since I exited. The same applies with Gigaset De sold two months ago. This is very annoying and I will perhaps have to endeavour to not let my trigger finger get quite so itchy if I own cheap stocks that I like.

I am pleased with the operational and market performance of my 3 largest longs, Energold, Microsoft and Yukon Nevada. The first two had very strong months up 15% and 13% whilst Yukon has delivered operationally and is starting to get recognition for that, up 9% today as I write on positive news flow.

From a broader market perspective I still think need to focus on two data points. The Shiller P/E is sitting at 21.8x which is a whisker short of the most expensive quintile in 130 years of data. In the context of this historically rich valuations we are still facing macro data that suggests a strong likelihood of a global recession. To quote John Hussman…

“While we typically discourage drawing inferences from any single indicator, it’s at least worth noting that with the release of Q4 GDP figures, the year-over-year growth rate of real U.S. GDP remains below 1.6% (denoted by the red line below). A decline in GDP growth to this level has always been associated with recession, usually coincident with that decline, though with a two-quarter lag in two instances (1956 and 2007), and with one post-recession dip in growth during the first quarter of 2003. As it happens, the GDP growth rate dropped below 1.6% in the third quarter of 2011.”

Other measures are also flashing caution, Corporate Profits to GDP are at extremely elevated levels relative to the last 70 years of data.

Meanwhile Average Joe is getting squeezed like never before. Wages/GDP have been grinding lower for 40 years but have accelerated their decline of late. When you think about the ramifications of this it becomes quite confusing. How can you be bullish on corporate profits or GDP when consumer spending, which is 70% of GDP, is fuelled only by household earnings from wages which are at a 40 year low relative to the economic pie? The other drivers of consumer spending – interest income, home equity withdrawals and credit cards are being crushed by central banks, negative equity and private sector deleveraging. I must be missing something.

It feels like we have gone up in a straight line since mid December with the S&P failing to post a single 1% decline day in that time. The VIX has dropped to 18, a level which frequently precedes sharp market declines. Investors are starting to think this is a “can’t lose market”. Maybe the blockbuster Facebook IPO frenzy will mark a top – if so then I will “like” Mr Zuckerberg.